Why we overprotect ourselves from the stock market

Even legendary investor Warren Buffet lamented recently the sad misfortune of those who parked their money in cash equivalents or fixed income investments, saying they have have missed the party over the past nine months as Wall Street rocketed to all-time highs.

“It is brutal. I don’t know what I would do if I were in that position,” Mr. Buffett said at Berkshire Hathaway’s annual meeting in Nebraska. “I feel sorry for people that have clung to fixed-dollar investments.”

Take the GIC, the best five-year rate among major banks is 2.2% at RBC. If held in a taxable account, the after tax return could be as low as 1.1%.

Over the past 12 months, an investor that was 60% invested in the TSX and 40% invested in the S&P 500 would have earned about 8% after fees compared to an armoured up investor who would have earned 2.2% locked into a five-year GIC.

And yet there is still $134-billion invested in GICs of five years or more as of December 2012, data from Investor Economics suggests.

Much of this was invested at rates a little higher than 2.2%, but there still remains some serious money invested at low rates, and the expectation is that much of it will be reinvested right back into GICs when it comes due.

A recent poll by Edward Jones found that a full 11% of Canadian investors don’t even know what they own. But of those that do, most are stubbornly holding on to cash and GICs and plan to add more of the same to their portfolios in 2013.

I believe a five-year GIC is an investing mistake today for two reasons.

1. People avoid stocks because of a fear of losses, even though over five-year periods, the chances of meaningful losses are very low, and there is a reasonable chance of significant gains.

2. Many people – especially retirees, feel that their investment time horizon is much shorter than it actually is. If they view their investments over a longer time horizon, then they might see that losses in diversified stock investments almost never happen.

A recent study from investment firm Franklin Templeton tries to better measure this fear. The study suggested that while 60% of Canadians think that the stock market will go up in the next year, half of Canadian investors indicated that they will be adopting a more conservative investment strategy in 2013. This compared to less than one quarter (22%) who will get more aggressive.

Investors often overprotect themselves from the risks of the stock market.

If we look at five-year periods since January 1950 the TSX would have outperformed a 2.2% return roughly 90% of the time. If you factor in fees of 2%, it still would have done better than a 2.2% return about 80% of the time. The worst five-year return was minus 1.9% or minus 3.9% including fees of 2%. The best five-year return was 25.8% after fees. So the five-year range was an outperformance of 23.6% down to an underperformance of 6.1%.

So it is true that you could do better in a GIC about 20% of the time (not factoring in taxes), but the downside is not too deep, and the upside you are giving up is significant.

I believe that if most investors used a 20-year time horizon, they would see an almost 0% chance of losing money

Now, if you believe that losing any money at all is not acceptable then you would buy the GIC. The question is why would you be so fearful of losing any money? Based on the past 60+ years, if investing in the stock markets for five years, the downside risk is fairly small.

What if based on history the downside risk was essentially 0%? Would that make the investment decision better?

I believe that if most investors used a 20-year time horizon, they would see an almost 0% chance of losing money.

I am often told by 70-year-old clients they don’t likely have a 20-year time horizon. In many cases I think they do have at least a 20-year time horizon on at least a large percentage of their savings.

Let’s say a 70-year-old couple has $500,000 in savings. Based on their expenses and other income, they expect to draw out $15,000 a year from this savings. Since they are in a ‘draw down’ stage they believe they must now be conservative with the bulk of their investments.

If that $500,000 grows 5% a year on average, then the $500,000 will actually grow by $10,000 every year even with the $15,000 withdrawals. In their case, I would suggest that the time horizon is at least 20 years, and probably 30 years plus.

The odds are that at least one member of this couple will be alive in 20 years so these investments need to last at least that long. If they can achieve 5% returns and draw $15,000 a year, then they will have over $760,000 in 20 years. They will effectively have had $500,000 at age 70, and proceeded to never touch the principal for 20 years. Based on that logic, the bulk of that money should have been invested reasonably aggressively.

Once they both pass away, what happens to the money? It will likely be inherited by their children who may even pass it down to the next generation. Now you are looking at a 30-year-plus time horizon for this money.

Over 20-year periods since 1950, the worst performance on the S&P 500 (US Market) was 7.0%, while the best was 19.4%. For the TSX, the worst was 6.2% and the best was 14.1%. Even if you factored in fees as high as 2%, and chose to use the worst performance period, a $100 investment in the S&P 500 would be worth $265 in 20 years. This is using the worst period and factoring in a relatively high 2% investment fee.

Maybe it’s time to shed some of the armour.

Written by Ted Rechtshaffen, President & CEO of TriDelta Financial.Reproduced from the National Post newspaper article 13th May 2013.